The WSJ has an article Profiting from the crash excerpting parts of the Gregory Zuckerman book The Greatest Trade Ever about John Paulson’s infamous bet against the housing market:
By early 2006 the 49-year-old Mr. Paulson had reached his twilight years in accelerated Wall Street-career time. He had been eclipsed by a group of investors who had amassed huge fortunes in a few years. It was the fourth year of a spectacular surge in housing prices, the likes of which the nation never had seen. Everyone seemed to be making money hand over fist. Everyone but John Paulson.
“This is crazy,” Mr. Paulson said to Paolo Pellegrini, one of his analysts.
Paulson’s response was to have Pellegrini look at the long term returns on house prices:
The answer was in front of him: Housing prices had climbed a puny 1.4% annually between 1975 and 2000, after inflation. But they had soared over 7% in the following five years, until 2005. The upshot: U.S. home prices would have to drop by almost 40% to return to their historic trend line. Not only had prices climbed like never before, but Mr. Pellegrini’s figures showed that each time housing had dropped in the past, it fell through the trend line, suggesting that an eventual drop likely would be brutal.
Paulson decided he wanted to bet that house prices would regress to the mean, but how to find the right instrument to allow him to do that:
By the spring, Mr. Paulson was convinced he had discovered the perfect trade. Insurance on risky home mortgages was trading at dirt-cheap prices. He would buy boatloads of credit-default swaps—or investments that served as insurance on risky mortgage debt. When housing hit the skids and homeowners defaulted on their mortgages, this insurance would rise in value—and Mr. Paulson would make a killing. If he could convince enough investors to back him, he could start a fund dedicated to this trade.
And then he stuck to his trade:
By the summer of 2006, Mr. Paulson had managed to raise $147 million, mostly from friends and family, to launch a fund. Soon, Josh Birnbaum, a top Goldman Sachs trader, began calling and asked to come by his office. Sitting across from Mr. Paulson, Mr. Pellegrini, and his top trader, Brad Rosenberg, Mr. Birnbaum got to the point.
Not only were Mr. Birnbaum’s clients eager to buy some of the mortgages that Paulson & Co. was betting against, but Mr. Birnbaum was, too. Mr. Birnbaum and his clients expected the mortgages, packaged as securities, to hold their value. “We’ve done the work and we don’t see them taking losses,” Mr. Birnbaum said.
After Mr. Birnbaum left, Mr. Rosenberg walked into Mr. Paulson’s office, a bit shaken. Mr. Paulson seemed unmoved. “Keep buying, Brad,” Mr. Paulson told Mr. Rosenberg.
What’s Paulson’s new big idea? Hint: It’s got distinctly Austrian tones:
By the middle of 2009, a record one in 10 Americans was delinquent or in foreclosure on their mortgages. U.S. housing prices had fallen more than 30% from their 2006 peak. In cities such as Miami, Phoenix, and Las Vegas, real-estate values dropped more than 40%. Several million people lost their homes. And more than 30% of U.S. home owners held mortgages that were underwater, or greater than the value of their houses, the highest level in 75 years.
As Mr. Paulson and others at his office discussed how much was being spent by the United States and other nations to rescue areas of the economy crippled by the financial collapse, he discovered his next targets, certain they were as doomed to collapse as subprime mortgages once had been: the U.S. dollar and other major currencies.
Mr. Paulson made a calculation: The supply of dollars had expanded by 120% over several months. That surely would lead to a drop in its value, and an eventual surge in inflation. “What’s the only asset that will hold value? It’s got to be gold,” Mr. Paulson argued.
Paulson & Co. had never dabbled in gold, and had no currency experts. He was also one of many warming to gold investments, worrying some investors. Some investors withdrew money from the fund, pushing his assets down to $28 billion or so.
Mr. Paulson acknowledged that his was a straightforward argument, but he paid the critics little heed.
“Three or four years from now, people will ask why they didn’t buy gold earlier,” Mr. Paulson said.
He purchased billions of dollars of gold investments. Betting against the dollar would be his new trade.
It is interesting to see a few well-respected investors on the same side of this trade. Einhorn made his views on gold known in his speech to the Value Investing Congress.
[…] bonds in his fund, Scion Capital. He figures prominently in the Gregory Zuckerman’s book, The Greatest Trade Ever, and also in The Big Short, Michael Lewis’s contribution to the sub-prime mortgage bond market […]
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[…] bonds in his fund, Scion Capital. He figures prominently in the Gregory Zuckerman’s book, The Greatest Trade Ever, and also in The Big Short, Michael Lewis’s contribution to the sub-prime mortgage bond […]
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DavidMIT: “People like Einhorn seem to play this by buying long-dated call options on interest rates. That sounds like a good hedge, as inflation will lead to higher interest rates. But how can a retail investor play this? any ideas?”
I’m not too knowledgeable about this and haven’t done anything, but I did think about doing it. But unlike you, I was thinking of doing the opposite bet (i.e. bet on deflation) and have contemplated it. Anyway, you have several choices as a small investor.
You can obviously bet on rising interest rates by shorting government bonds, or buying inverse bond ETFs (for example, TBT for inverse long-term bonds–do note that the path taken by returns matters for inverse and leveraged ETFs.) You won’t get the leverage of derivatives but this is the simplest.
The other alternative I can think of (and this is closer to the leveraged bets of macro speculators) is to buy options on bond ETFs. Since you are bearish on bonds (or bullish on interest rates,) you can buy put options on government bond ETFs. For example, you can buy a Jan 2011 put option on TLT (TLT is a 20 year bond ETF). Conversely, you can buy a call option on an inverse bond ETF but volume for inverse bonds are not good and inverse ETFs depend on the path taken (i.e. it’s possible for you to lose money even if the bond falls.)
Going with put options provides huge leverage but it is complicated (pricing them is not easy), can result in total loss, and is very expensive (depending on the option in question, you may pay as much as 10% for the priviledge of entering into the contract.)
Whatever happens, do keep in mind that macro bets are pretty much speculation and has nothing to do with “value investing.” It is very difficult to “prove” that interest rates must necessarily rise. Similarly, it’s not so easy to justify that gold must necessarily rise.
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People like Einhorn seem to play this by buying long-dated call options on interest rates. That sounds like a good hedge, as inflation will lead to higher interest rates. But how can a retail investor play this? any ideas?
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I’ve also seen people buying Swiss Franc instead of gold on the theory it’s more stable.
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I agree with the underlying thesis that the US dollar is going to shit. In my mind, there is no doubt that the US government’s borrowing costs will rise significantly in the near future.
However, I just can’t wrap my head around buying gold. I understand that historically, gold has kept its value or risen when the value of fiat currency comes into question, but aside form gold’s minor worth for aesthetic and production purposes, its just a metal. It is not a security. How can there not be a better way to play this investment thesis??? Julian Robertson’s curve steepeners make much more sense to me.
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